A bond is just an organization's IOU; i.e., a promise to repay a sum of money at a certain interest rate and over a certain period of time. In other words, a bond is a debt instrumenty. Other common terms for these debt instruments are notes and debentures. Most bonds pay a fixed rate of interest (variable rate* bonds are slowly coming into more use though) for a fixed period of time.
Why do organizations issue bonds? Let's say a corporation needs to build a new office building, or needs to purchase manufacturing equipment, or needs to purchase aircraft. Or maybe a city government needs to construct a new school, repair streets, or renovate the sewers. Whatever the need, a large sum of money will be needed to get the job done.
One way is to arrange for banks or others to lend the money. But a generally less expensive way is to issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further agree to redeem the bonds (i.e., buy them back) at some time in the future (the redemption date). This process is nothing but the taking back of the certificate and returning of the principal.
Companies of all sizes issue corporate bonds. Bondholders are not owners of the corporation. But if the company gets in financial trouble and needs to dissolve, bondholders must be paid off in full before stockholders get anything. If the corporation defaults on any bond payment, any bondholder can go into bankruptcy court and request the corporation be placed in bankruptcy.
Municipal bonds are issued by cities, states, and other local agencies and may or may not be as safe as corporate bonds. The taxing authority of the state of town backs some municipal bonds, while others rely on earning income to pay the bond interest and principal. Municipal bonds are not taxable by the federal government (some might be subject to A Minimum Tax, AMT) and so don't have to pay as much interest as equivalent corporate bonds.
U.S. Bonds are issued by the Treasury Department and other government agencies and are considered to be safer than corporate bonds, so they pay less interest than similar term corporate bonds. Treasury bonds are not taxable by the state and some states do not tax bonds of other government agencies. Shorter-term bonds are called notes and much shorter term bonds (a year or less) are called bills, and these have different minimum purchase amounts.
In the U.S., corporate bonds are often issued in units of $1,000. When municipalities issue bonds, they are usually in units of $5,000. Interest payments are usually made every 6 months.
The price of a bond is a function of prevailing interest rates. As rates go up, the price of the bond goes down, because that particular bond becomes less attractive (i.e., pays less interest) when compared to current offerings. As rates go down, the price of the bond goes up, because that particular bond becomes more attractive (i.e., pays more interest) when compared to current offerings. The price also fluctuates in response to the risk perceived for the debt of the particular organization. For example, if a company is in bankruptcy, the price of that company's bonds will be low because there may be considerable doubt that the company will ever be able to redeem the bonds.
On the redemption date, bonds are usually redeemed at "par", meaning the company pays back exactly what the bondholders paid it way back when. Most bonds also allow the bond issuer to redeem the bonds at any time before the redemption date, usually at par but sometimes at a higher price. This is known as "calling" the bonds and frequently happens when interest rates fall, because the company can sell new bonds at a lower interest rate (also called the "coupon") and pay off the older, more expensive bonds with the proceeds of the new sale. By doing so the company may be able to lower their cost of funds considerably.
Who buys bonds? Many individuals buy bonds. And of course Investment banks like Goldman Sachs buy bonds. Banks buy bonds. Money market funds often need short-term cash equivalents, so they buy bonds expiring in a short time. People who are very adverse to risk might buy US Treasuries, as they are the standard for safety. Foreign governments whose own economy is very shaky often buy Treasuries.
y Debt instruments are nothing but loans taken by either company or the govt. or the municipality. There are various types of debt instruments like debenture, bond, notes, bills and many more. The name varies depending upon the issuer or nature of the instrument. But one common characteristic of most of them is that, they all carry some coupon Interest rate. I say most and not all because Zero coupon bonds do not carry any coupon rate. We will discuss about these instruments else where in this document.
* Variable rate of interest: The interest of these securities are linked to some reference rate, many cases to LIBOR (London Inter Bank Offer Rate). They may be some basis points above LIBOR, say 200 basis points. This means LIBOR + 2%. If LIBOR is 5%, then the interest comes to 7%. Depending upon the LIBOR movement, the interest rate on the bond also varies.
No comments:
Post a Comment